The idea of “decentralized finance” is not new anymore. It has become so popular that regular investors are a big part of how the blockchain-powered DeFi universe is growing. This article will help you understand what LP tokens are, how they work in DeFi, and the risks associated with them.
What is the relationship between LP tokens and Automated Market Makers?
When talking about liquidity providers (LP) tokens, the role of liquidity providers in the crypto world would be a good place to start. Anyone who follows blockchain and cryptocurrencies closely has probably heard that DeFi services are always constantly evolving. The growth of the DeFi ecosystem has led to new ways to access financial services. Automated market maker (AMM) platforms like Uniswap, Curve, etc. are a key part of DeFi ecosystem, which is growing quickly, and they offer a new way to trade in general.
The LP tokens are a key part of the way that automated market maker platforms work. Since DeFi platforms don’t have a central middleman like a bank, they need to find a way to make sure that buyers and sellers can find each other. In the DeFi market, this is called an automated market maker, which is a pre-programmed algorithm that connects buyers and sellers on its own. AMMs, on the other hand, let traders trade directly with a pool of assets instead of with other buyers or sellers.
What does it mean to provide liquidity?
Liquidity in cryptocurrency markets basically means how easy it is to trade one token for another without causing a big change in price. But not all tokens are lucky enough to have a high level of liquidity that makes it easy to trade without causing the price to change by a lot. Liquidity can be low when it comes to DeFi and smaller projects. For instance, the coin might only be on one exchange and you may also find it hard to match your order with a buyer or seller. The liquidity pool model, which is also called “liquidity mining” in some places, is the answer to these issues.
Users who deposit a pair of tokens into the pool to enable trading are known as liquidity providers, the quantity provided by them would be in the form of a token pair, which is locked in smart contracts and is used to provide liquidity. The liquidity they provide is deposited into a liquidity pool, which is used in most cases, by decentralized exchanges. A liquidity pool is designated by the token pair it represents. For example, ETH-USDC is a liquidity pool that includes liquidity for the token pairs ETH and USDC.
How do liquidity pool (LP) tokens work?
In 2020, there was no such thing as “yield farming.” Today, you can “farm for yield,” or make the most money possible, by adding and removing your LP tokens from different DeFi apps. A liquidity pool is a smart contract where tokens are locked for the purpose of providing liquidity. In terms of how they work, they aren’t very different from other tokens on the same network. For example, Uniswap and Sushiswap are both Ethereum-based platforms, and their LP tokens are ERC20 tokens. They may be transferred, sold, and staked on other protocols just like any other ERC20 token.
LP tokens represent a liquidity provider’s share of the liquidity pool, and liquidity providers have full control over the tokens. For example, if you add $10 to a liquidity pool with $100 in it, you could claim around a 10% stake in the liquidity pool. You would receive 10% of the LP tokens as proof of ownership of 10% of the liquidity pool.
Holding LP tokens offers liquidity providers total control over their locked liquidity, just like any other token. Most liquidity pools enable providers to redeem it at any time without penalty, however, some may levy a small fee if they are redeemed too quickly.
At the most basic level, this is how LP tokens work:
Total Value of Liquidity Pool / Circulating Supply of LP Tokens = Value of 1 LP Token
What can I do with liquidity pool (LP) tokens?
There are many other use cases for LP tokens that are emerging on modern DeFi platforms. These include:
With yield farming, there are two ways to boost your profits. To earn compound interest, you can either manually transfer your tokens between different DeFi protocols or you can deposit your LP tokens into the liquidity pools of different protocols that can help you earn compounded interest.
To move your tokens manually, you must first deposit a pair of crypto tokens into a liquidity pool on a DeFi protocol, and then deposit the LP token you get into another protocol. With your liquidity provider token, you can make money in two ways: as a liquidity provider and by farming yields.
Collateral in a loan
You can use LP tokens as collateral to secure a crypto loan. Crypto lending, in which lenders receive interest from borrowers, has become a popular DeFi product. For example, if you provide BNB, ETH, or BTC as collateral for a crypto loan, some platforms allow you to offer your LP tokens as collateral. Typically, this will enable you to borrow for a stablecoin or other large market cap asset.
Participating in IDOs
An initial DEX offering (IDO) is a crypto token offering held on a DEX. People who own LP tokens on a certain DEX can invest in a new cryptocurrency project through DEX’s IDO.
What are the risks associated with LP tokens?
By now you should be familiar with how LP tokens work and how it is useful for both decentralized exchanges as well as users who want to earn some side income by providing their crypto assets to liquidity pools. However, there are risks associated with it, which include:
1. Loss or theft: Your stake in the liquidity pool and any interest earned will be forfeited if you lose your LP tokens.
2. Smart contract failure: So, if there is a hack or security breach, you could lose all of your LP tokens and the original crypto you put into a liquidity pool.
3. Difficulty in knowing what they represent: It’s almost impossible to tell what your LP tokens are worth just by looking at them. If the prices of tokens have changed, you will also have incurred the impermanent loss. Due to these factors, it can be hard to decide when to get out of your liquidity position in a smart way.
4. Opportunity risk: There is a cost associated with providing liquidity with your tokens, because once you decide to lock your tokens into a liquidity pool, you may miss out on other opportunities in the crypto market. In some situations, it might be better to invest your tokens somewhere else or use them for something else.
LP tokens are a very important part of DeFi. Not only do they help figure out your share of the liquidity pool, but they can also be used for yield farming, as collateral, and to transfer value. It’s an intriguing way to earn passive income from your crypto assets, even though they come with risks. I hope you’ve learned a little bit about LP tokens, how they work, and how risky the feature is. So instead of just HODLing during this bear market, look at your investment plans and how comfortable you are with taking risks to decide if liquidity-providing investments are right for you.